NBER Working Paper No. 3116Issued in September 1989NBER Program(s): ME

In this paper we provide some econometric evidence on the impact of financial factors like cash flow, debt and stock measures of liquidity on the investment decisions of U. K. firms. These variables are introduced via an extension of the Q model of investment which explicitly includes agency/financial distress costs. We discuss if the significance of cash flow may be due to the fact that it proxies for output or because it is a better measure of market fundamentals than Q. Moreover we investigate if the effect of financial factors varies across different types of firms, according to size, age, and type of industry (growing and declining). We analyze the determinants of the magnitude of the cash flow effect and explain why caution must be exercised in attributing inter-firm differences only to differences in the importance of agency or financial distress costs.